China’s earthquake opens fault-lines in debt-fuelled ‘ring of fire’

We can all hope that China’s ‘collateral trade’ turns out not to be as big a problem as seems likely. But history shows that this type of problem has a way of escalating once people start investigating more closely.

Thus state-owned Citic revealed yesterday that it has lost $40m in the Qingdao scandal, as half of its alumina is missing. And, of course, this is only what it knows to be missing. We also learnt that local Chinese banks may have Rmb 15bn ($2.4bn) in outstanding loans to Dezheng Resources, the company at the centre of current investigations.

The key issue is that nobody can tell today the depth of the problem:

Maybe this is just one company, with one set of deals that went wrong?

Maybe the vast majority of China’s commodity imports have indeed been used to create future income?

Maybe China’s housing market is not as overvalued as it appears, and may stabilise at today’s levels?

Maybe the government will reverse course and do another 2008-type stimulus to try and resolve the situation?

But maybe only some, or none, of the above turns out to be true? The Qingdao scandal has now been running since April, when Dezheng’s founder was first detained. And as the Financial Times reports:

“The case has cast a chill over metals trading in China, the world’s largest consumer. Chinese customers and traders are now often unable to find loans for imports as Chinese and international banks pull back from a practice once viewed as safe….

“China’s central bank ordered banks in Shandong province to approve import financing from their provincial offices, rather than their city branches, on the same day that police formally began investigating the multiple claims on the metal.

Day by day, the story refuses to die down. Instead, more and more details emerge to suggest it may get worse.

It therefore seems prudent to adopt the Scout motto of “Be Prepared” and try to identify a ‘worst case’. The reason is simple – history shows, as during the sub-prime Crisis, that there is little time to react once the wider market becomes aware of the potential problem.

WHAT MIGHT HAPPEN NEXT, IN A WORST-CASE SCENARIO?
First to be hit would likely be the global commodity markets, if they wake up one morning to find that China’s vast ‘collateral trade’ is starting to unwind, perhaps rather suddenly:

The prices for those metals and other commodities caught up in the trade would be hit first

Mining company shares would also be hit, as people worried their vast capacity expansions were wishful thinking

Investors may put 2 and 2 together and worry, as the BBC described in February, that “China Fooled the World”

Next to be hit could be other financial markets. Complacency and low interest rates have encouraged investors to borrow heavily. Each night, therefore, they might start to receive margin calls as prices for their commodity-related investments decline:

At the same time, buyers might then immediately disappear for anything that appears to be high-risk

A third phase of the downturn could then develop in our globally-linked electronic world:

These forced sellers might have to sell in more liquid markets to secure the cash they need

This would mean selling blue-chip shares and high-quality government bonds

In turn, investors who have borrowed heavily to invest in these markets would then start to receive margin calls

The risk is therefore that major declines could then take place quite suddenly in a number of major financial markets, just as Hyman Minsky would have forecast:

His insight was that a long period of stability eventually leads to major instability

This is because investors forget that higher reward equals higher risk

Instead, they believe that a new paradigm has developed

They therefore take on high levels of debt, in order to finance ever more speculative investments

As in 2008, another ‘Minsky moment’ could thus occur as ‘distress sales’ start to take place.

Let us hope that none of this happens. But what would your company do, if some or all of these events start to take place? That is the key question that we all now need to answer.

CONCLUSION – THE WORLD COULD EASILY BECOME A SCARY PLACE
None of this would have happened if central banks had accepted that ageing populations inevitably lead to low levels of economic growth. The New Old 55+ generation are a replacement society, as they already own most of what they need, and their incomes decline as they enter retirement.

But the central banks didn’t want to do this. Instead, they have provided a fig-leaf behind which politicians could hide, to avoid a difficult debate with the voters about the need for pension age to rise, not fall.